The global financial crisis has been providing economists with an opportunity to present the old basics of finance as new insights. Non-economists often seem to misunderstand the functions of financial markets—the current mess reinforces a prior view that finance is just a complex way of stealing people’s money. What is finance really about?
Stripping to the essentials, financial transactions are motivated by individuals’ desires to change their pattern of income or wealth across different states of the world, or across different time periods. If two individuals have complementary desires (e.g., one wants to save now and spend more later, and another the reverse), they can engage in mutually beneficial trades (the current saver lends or extends credit to the borrower). Trading across different contingencies allows individuals to adjust the riskiness of their patterns of income to suit their preferences better. These are the most basic financial transactions, and they could potentially be conducted directly by individuals—if they always were, there would be no financial services sector. Instead, finance is all about various kinds of intermediation between individuals, groups or institutions. What roles do financial intermediaries play? Here are seven examples.
• Economizing on the costs of completing and implementing transactions. Digital technology has made the form-filling aspects less important. Complex contracts require lawyers as intermediaries, but that is not strictly a financial service. In general, technology has reduced the importance of this role for intermediaries.
• Matching buyers and sellers. Financial exchanges serve this role very well. What is surprising is how many financial assets are still not traded on exchanges, so intermediaries get to play the matching role in a non-transparent manner, which hinders efficiency. Exchanges do not work for every kind of financial asset, but greater transparency could be achieved for non-exchange financial transactions, using clearing houses for example.
• Economizing on search costs. Search can be a precursor to matching, with or without an intermediary. Financial intermediaries provide information for buyers and sellers of financial products. Much of this is basic financial data and news. The crisis has shown that simply having easy access to large quantities of information does not ensure successful market functioning, but still, more information is generally better to have.
• Providing expertise. One area where this expertise provision failed was in rating the quality of newer types of securities, such as those derived from bundling mortgages. This was partly because the experts were not really experts, and partly because their pay scheme eroded their neutrality. In general, information availability increased in financial markets, but expertise has lagged considerably.
• Smoothing the market. Financial intermediaries can carry inventories of financial assets, using those to manage fluctuations and make sure buyers and sellers can carry out plans, providing liquidity as a result. This role broke down in one phase of the crisis, partly because large volumes of new kinds of financial assets were being traded without the kinds of inventory requirements that govern stock exchanges or banks.
• Providing reputation. When buyers and sellers are not long-run market players, intermediaries become crucial sources of trust. Both sides of the market will trust intermediaries who have strong reputations that they seek to protect from damage or erosion. Reputations can be falsified (Bernard Madoff), so disclosure and external monitoring may also be required, but they can also be very powerful. The US’ reputation is keeping its financial system going, even after negligence and incompetence has been revealed in many of its components.
• Transforming products. With physical products, transformation can go only so far. Distributors change the products’ locations. Wholesalers and retailers may tinker with packaging. In the case of financial products, however, there is seemingly no limit to the transformations possible, and derivative securities are completely “new” financial assets created on top of existing ones. Transformation used to mean simple cases of bundling individual assets into securities that would reduce the risk borne by any single asset holder, but now has gone far, far beyond that.
Discussions on how to improve regulation of the financial sector often are limited by starting from current institutions, and thinking of adjustments to these institutions. Boundaries between institutional categories, determined by historical legacies, are often taken as given. A more productive approach to considering regulatory reform could be to first answer the question, “What are the economic roles of financial institutions?” (invariably some form of intermediaries), as I have done here. This framework can be used to identify what has not been working well, and why not. It can be used to examine how different roles fit together, and if systems are becoming unbalanced. As transformations of financial products exploded, Alan Greenspan argued that incentives to maintain reputation were all that mattered, but meanwhile, expertise and matching functions were lagging far behind. In financial markets we have to accept self-interest— even greed—but we do not have to accept inefficient institutions.
Nirvikar Singh is a professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org